the Principal On an Interest-Only Loan
I just bought my first house, and I have an "interest only"
mortgage. That is, for five years I've got a rate locked in
and I only have to pay the interest on the loan. Hence, my mortgage
payment is about $1,900 a month. Five years from now, the rate
adjusts up and I will have paid down zero principal on the $475,000
it worth it to pay, say, $2,000 or $2,100 or even $2,500 (if
it's a good month) whenever I can to chip away, however incrementally,
at my principal over the next five years? Or am I better off
saving any extra cash and investing it, at a time when money
markets are paying less than 1% and the stock market is so volatile?
Steve, location not provided
You may well be better off investing your money rather than
paying down principal, but much will depend on your tolerance
Americans assume it's always best to pay down their mortgages
as quickly as they can. But in a lot of cases that's not always
true; indeed, that's the whole idea behind an interest-only
the uninitiated, interest-only mortgages work like this: First,
the borrower takes out a 30-year mortgage, electing to pay only
interest for a set period of time, such as five, 10 or 15 years.
After that, the monthly payments readjust to include the principal,
amortized over the remaining years of the loan. This can cause
the monthly payments to rise substantially.
advantage of an interest-only loan is that it allows a borrower
to free up capital to invest in assets that yield the highest
return, or serve some particular financial-planning purpose,
rather than locking it up in a house. For example, you could
take the money you'd be paying in principal each month and invest
it in the stock market. Or, you could set it aside to help pay
for a child's college fund.
you have $100 in extra funds one month and you're trying to
decide whether to invest it or pay down principal on your house.
If you devote the money to paying principal, you'll wind up
reducing your interest-only mortgage payments by $4 over a year's
time, according to a scenario constructed by Bankrate.com, the
personal-finance website. But you won't be able to deduct as
much interest as before from your taxes. If you're in the 28%
tax bracket, you'd wind up with a tax deduction that's $1.12
smaller than before. So your net savings would be $2.88 over
the year, which equals a 2.88% annual rate of return after taxes,
by Bankrate's calculations.
a far cry from the 8.5% average annual after-tax return that
investors generally expect from the stock market over the long
haul. Of course, that's where your tolerance for risk comes
in. Everyone knows the stock market has been volatile lately,
and if your idea of stock investing is to load up on shares
of some hot new tech stock, you might want to just pay off your
mortgage. But if you're willing to park your money in a diversified
mix of stocks long enough to ride out any cyclical ups and downs,
you should be in good shape. You certainly wouldn't want to
put the money in a money-market fund. Given current market conditions,
you'd be lucky to eke out a 1% annual rate of return from those
are other scenarios in which it makes sense to skip paying principal.
For example, if you have huge amounts of credit-card or other
high-interest debt, it might be best to take the money you have
earmarked to pay down principal and use it to pay down your
other, more expensive debt. Or, say your employer has a program
to match your contributions to a 401(k) plan. If you're not
taking full advantage of that program, you might want to use
the money you had set aside for principal payments to boost
your monthly 401(k) contribution.
those and some other scenarios, "you won't have paid down
your mortgage at all, but your financial picture outside your
mortgage will be much more robust," says Bob Walters, the
chief economist at Quicken Loans, an online lender based in
Livonia, Mich. He says about 15% to 20% of his company's clients
are taking out interest-only loans these days, and the percentage
is rising as home prices and interest rates climb.
be sure, there are plenty of pitfalls in not paying down your
principal. For one thing, you'll be building up less equity
in your home. That shouldn't be a big problem, since you will
be accumulating equity as the property appreciates in value.
But if you think you live in a market where prices aren't likely
to rise much, or might fall, you might want to pay down some
of the principal to give yourself an extra cushion of equity.
also need to know yourself: Are you the kind of person who will
have the discipline to invest wisely or pay down other debt
if you don't pay down your principal? "If you take the
money and go out to Vegas, that's a bad idea," says Mr.
Walters at Quicken Loans. You also need to be careful not to
use an interest-only loan to get yourself overextended. Some
borrowers take out interest-only loans so that they can afford
much bigger houses than they'd be able to buy otherwise, only
to get whacked later when the loan readjusts once the interest-only
period is over.
The basic point is that you need to think hard about your long-term
financial goals and your investment strategies before deciding
what to do. If you're more comfortable taking the more conservative
route and paying down your mortgage early, by all means do it.
You'll sleep more easily at night. But if you know what you're
doing when it comes to smart investing, your money can go farther
if it's invested somewhere else rather than tied up in your